Daily Archives: 15th November 2018
Daily Archives: 15th November 2018
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It doesn’t get more exciting than when one can smell some political bloodletting. The great Sword of Damocles dangles over PM Theresa May, following an eruption of massive proportions around the Brexit “agreement”. For most, it clearly and rightly dominated the day.
It should not have been so – or the timing was just not great – because we also had that massive 6-part offering from Takeda Pharmaceutical Company Ltd to contend with. Alas, the credit fraternity were focused as much as they could be on filling their boots of this mega-deal, coming cheap as the borrower needed to pay-up for size. As we stated in previous comments, size opens eyes.
So, here we are. The UK government agrees a draft Brexit deal with the EU and yet markets fret about the uncertainty in terms of whether it will be approved and if a hard Brexit can be avoided. Without going into the consequences of the final outcome, the UK banks that are most exposed to the domestic economy are most vulnerable and that is seen in stock price reaction for the likes of Barclays, Lloyds and RBS.
In fact, RBS is down almost 10% on fears that the bank may face an uncertain future if there is a change in government. So clearly, there is significant uncertainty coming our way over the coming weeks and hence a very clouded negative outlook.
Whilst it is difficult at this stage to be very precise about the exact negative consequences of a hard Brexit and its impact on the banks, one could carry a stress test on the balance sheets and get an idea of how much capital erosion may happen.
The BOE is due to publish the 2018 annual stress test results on 5 Dec 2018 and that will give us more clarity on the state of capital at the large UK banks. However, last year’s annual stress test results published in Nov 2017 do give us enough insight about the capital situation.
In the 2017 stress tests, the following parameters were used to assess the deterioration in capital levels at the various institutions and if any capital actions were required:
Under the above scenario (very stringent in my view), in last year’s stress test, all of the banks came out well with none requiring any additional capital actions. In the test, banks incur losses of around £50 billion in the first two years of the stress. The stress reduces the aggregate CET1 capital ratio from 13.4% at the end of 2016 to a low point of 8.3% in 2018. The aggregate Tier 1 leverage ratio falls by 1.1 percentage points, from 5.4% at the end of 2016 to a low point of 4.3% in 2018.
Barclays and RBS had the biggest drops in core capital and did not meet the CET1 capital ratio “systemic reference point” using the end of 2016. But as the report mentioned, since then both banks have increased their CET1 capital ratios and hence no action was required. Just as a point of reference, Barclays CET1 ratio has increased from 12.4% at end 2016 to 13.2% at end Q3 2018 and RBS has increased its CET1 ratio from 13.4% at end 2016 to 16.7% at end Q3 2018. Using similar parameters for the stress test, it seems that overall losses are still an earnings event and not a solvency event for any of the large banks.
Without going into the details, RBS seems to be in the best position to handle large losses from a severe economic shock given its starting CET1 ratio followed by Lloyds and Barclays. HSBC and Standard Chartered Bank seem to fare reasonably well but that is a function of their business model (and more reliant on what happens in EM, especially in Asia)
To me, the real question is what happens if a triple combo tail risk event were to happen in one go (hard Brexit, sharp slowdown in global growth and a full-blown EZ/EU crisis) leading to a dramatic drop in revenues and significant loan losses to be incurred over a very short period of time. In such a shock scenario, the CET1 ratios of the banks come under pressure with the likes of Barclays, Lloyds and Standard Chartered not faring that well. Even in that scenario it seems that minimum solvency ratios are not breached but certain regulator-imposed ratios (Pillar 2 requirements, MDA for AT1 coupons) may yet be breached.
Clearly equity investors are going to nervous owning UK banks (especially those who domestically focused and/or have government ownership) primarily due to earnings at risk and we could yet see further drops in stock price.
It is in AT1 land (in particular the GBP issues) that I sense the biggest risk to price drop given the limited investor base and even more limited liquidity. If anything, the USD AT1 issued by Lloyds and HSBC seem the most defensive to own given the back-ends whilst the ones issued by Barclays, RBS and Standard Chartered seem the most exposed for varied reasons. Having said that, if the USD AT1s issued by Barclays and RBS were to significantly drop in price and if yields to perpetuity were to reach 8% and above, they would be very attractive to own/add, more so relative to owning the respective bank’s equity.
In LT2 and HoldCo Senior, current valuations seem just about fair for the risks outlined but can they get cheaper and more attractive over time? The answer is a resounding “Yes”.
Hence my title that owning sub-debt in the UK banks is like owning BBB- negative outlook paper and the transition from one set of investors to another may yet turn out to be painful, to say the least.